FINANCIAL CONTROLS AND OPERATING CONTROLS FOR INVENTORY AND PURCHASES TRANSACTIONS & LONG TERM ASSETS

Inventory and Cost of Goods Sold Frauds

Inventory ² includes all the goods a company owns and holds for sale in the normal course of operations; it is a merchandiser·s most important asset.

Cost of Goods sold ² is the entity·s cost of its inventory that has been sold to customers. It is the merchandiser·s major expense.

Ending inventory Cost of goods sold .Effect of Cost of Goods Sold on Inventory Cost of Goods Sold Overstated Ending Inventory No effect No effect No effect No effect No effect Overstated Understated Understated Purchases No effect Understated No effect No effect Understated No effect Understated Beginning Inventory + Purchases of inventory .Purchase discounts on inventory purchases Goods available for sale .Returns of inventory to vendor .

Sales returns .Sales discounts Net Revenues (sales) .Cost of goods sold Gross Margin .Income Statement Gross Revenues (sales) .Expenses Net Income Overstated Inventory No effect No effect No effect No effect Understated Overstated No effect Overstated .

recognize cost of goods sold NO Inventory is obsolete? YES NO 6 Write down inventory NO Inventory counted? 7 Estimate inventory YES 8 count inventory 9 determine inventory costs .1 Purchase inventory YES Return goods? NO YES Take discount? 2 Return merchandise to supplier 3 Pay vendor within discount period NO 4 Pay vendor w/o discount Sell inventory? YES 5 Sell inventory.

Transaction 1. Purchase inventory Fraud Schemes ‡Underrecord purchases ‡ record purchases to late (cutoff problem) ‡ not record purchases ‡ Overstate returns ‡ record returns in an earlier period (cut-off problem) ‡ Overstate discounts ‡ Don·t reduce inventory cost ‡Don·t reduce inventory cost ‡ Record purchase and payment in a later period ‡ Record at too low an amount ‡ Don·t record cost of goods sold or reduce inventory 2. Return merchandise to supplier 3. Sell inventory. recognize cost of goods sold . Pay vendor within discount period 4. Pay vendor without discount 5.

etc) ‡ Overcount inventory (double counting. Estimate inventory 8. Count inventory 9. Write down inventory (it becomes obsolete) 7. etc.Transaction 6. Determine inventory costs Fraud Schemes ‡ Don·t write off or write down obsolete inventory ‡ Overestimate inventory (overestimate ratio. ) ‡ Use incorrect costs ‡ Make incorrect extensions ‡ Record fictitious inventory .

Identifying inventory fraud symptoms Analytical Symptoms ‡ reported inventory balances appear too high or are increasing too fast ‡ reported cost of goods sold balances appear too low or are decreasing too fast ‡ reported purchase returns and discounts appear too high or are increasing too rapidly ‡ reported purchases appear too low for inventory levels .

accounting period. classification.Identifying inventory fraud symptoms Accounting or Documentary Symptoms ‡ inventory and/or cost of goods sold transactions are not recorded in a complete or timely manner or are improperly recorded as to amount. only photocopies are presented . or entity ‡ inventory / cost of goods sold-related transactions are unsupported or unauthorized ‡ end-of-period inventory and/or cost of goods sold adjustments significantly affect the entity·s financial results ‡Inventory and/or cost of goods sold documents are missing ‡ original documents to support inventory and/or cost of goods sold transactions are unavailable.

) ‡ cost of goods sold-related accounting records do not balance ‡ unusual discrepancies exist between the entity·s inventory and/or cost of goods sold records and corroborating evidence ‡ inventory counts and inventory records differ systematically ‡ receiving reports and inventory actually received differ ‡ purchase orders.Accounting or Documentary Symptoms (cont·d.. and inventory records differ ‡ purchases for suppliers are not approved on vendor lists ‡ inventory is missing ‡ purchase orders or invoice numbers are duplicated ‡ vendors are not listed in telephone directories . invoices. receiving records.

Identifying inventory fraud symptoms Control Symptoms ‡ management overrides significant internal control activities related to purchases. inventory and/or cost of goods sold ‡ new our unusual vendors do not go through the regular vendor-approval process ‡ weakness in the inventory counting process exist .

vague. or others from whom evidence might be sought ‡ undue time pressures are imposed by management to resolve contentious or complex inventory and/or cost of goods sold-related issues. vendors. employees.Identifying inventory fraud symptoms Behavioral or verbal symptoms ‡ management or employees give inconsistent. or implausible responses to inventory. . customers. or cost of goods-related inquiries or analytical procedures ‡ auditors / investigators are denied access to facilities. purchase. records.

vendors or accounts .Identifying inventory fraud symptoms Behavioral or verbal symptoms ‡ unusual delays occur in providing requested inventory and/or cost of goods sold ² related information ‡management responses to inventory and/or cost of goods sold or other queries made by auditors are untrue or questionable ‡ the behavior or responses of management are suspicious when they are asked about inventory and/or cost of goods sold related transaction.

cash disbursements. processing. ‡ a study found that most companies that commit financial statement fraud are relatively small & have inactive audit committees ‡ primary concern on controls over purchasing process.Searching for inventory control symptoms ‡ a good control environment and control procedures are crucial. transferring the cost of inventory sold. and physical inventory . recording of liabilities. storage. shipping of inventory. receiving. tracking inventory costs.

‡ identify inconsistencies between what you observe and what management tells . and other characteristics of inventory as well as inventory levels. ‡ ask detailed questions about nature. significant changes in vendors. ‡ best evidence of intent comes from inquiries to management.Searching for behavior and lifestyle flags ‡ often. recorded inventory amounts are subject to management s intent. salability. age.

Searching for tips and complaints ‡ many people are involved in managing the physical flow of inventory. ‡ talk to the people who actually handle the inventory ‡ communicate with vendors and determine their relationships with the company .

Focus on changes in statement numbers 2. 2.Searching for analytical symptoms Analysis of Period-toperiod changes Inventory account balances 1. Compare statement amounts with the assets they are supposed to represent Comparison of statement accounts With industry competitors 1. Examine changes in relevant ratios With real-world numbers 1. Use horizontal analysis Inventory relationships 1. Study statement of cash flow 3. Compare statement results with similar co.·s trends with those of similar co. Compare the co. 2. Use vertical analysis .

Period-to-period changes in relationships ‡ Gross profit margin = Gross profit / sales ‡ Inventory turnover = cost of goods sold / average inventory ‡ Number of days sales in inventory (days in a period inventory turnover) .

Period-to-period changes in relationships ‡ asset turnover inventory comprises a large percentage of the total assets ‡ working capital turnover ‡ operating performance ratio profit margin of a company ‡ earnings per share organization. measures the profitability of an .

Comparing companies· financial statements ‡ maintaining large amounts of inventory is expensive ‡ high inventory levels are signs of management ineptitude and lack of efficiency in operations ‡ increasing inventory levels are questionable especially when competing firms are not increasing their inventories ‡ economic and industrywide factors tend to affect similar firms in similar ways .

Comparing statement amounts with actual assets ‡ excellent way to detect fraud .

.LONG TERM ASSETS FRAUD Long term assets ² are assets other than current assets. One category of long-term assets is plant assets (also called fixed assets). Other categories of long-term assets include longterm investments and other assets.

. certain salaries and other initial costs ‡Capitalizing costs that should be expensed increases net income by the same amount of the capitalized cost. research and development. advertising costs.Improper Capitalizing or Expensing ‡Start-up companies often overstate assets by capitalizing as intangible assets such things as start-up or pre-operation costs. marketing costs.

Overstating fixed assets 1. they are obsolete. Inflated amounts are recorded in non-arm s=length purchase transactions 2. or their values are otherwise impaired 3. Nonexistent assets are recorded in statement accounts . market or residual values because insufficient depreciation is recorded. Assets are not written down to appropriate book.

Analytical Symptoms ‡Total fixed assets / total assets ‡Individual fixed asset account balances / total fixed assets ‡Total fixed assets / long term debt ‡Depreciation expense for various categories of assets / assets being depreciated ‡Accumulated depreciation / depreciable assets (per asset category) .

Accounting or Documentary Symptoms ‡Were there appraisals of purchased fixed assets? ‡Were the purchase transaction recorded near year-end? ‡Did the transactions involve exchanges of assets or a purchase of assets? ‡Are the assets purchased assets that this company would normally purchase or are they tangential to the business? ‡Are there inconsistencies in the documentation? ‡Are the assets recorded on your client·s books at the same or lower amounts as on the seller·s books? .